Krugman Asks a Key Question on the Financial System

So here’s the question we really should be asking: When the feds do bail out the financial system, what will they do to ensure that they aren’t also bailing out the people who got us into this mess?

The prognosis, of course, is quite grim:

Still, that’s not what has me worried. I’m more concerned that despite the extraordinary scale of Mr. Bernanke’s action — to my knowledge, no advanced-country’s central bank has ever exposed itself to this much market risk — the Fed still won’t manage to get a grip on the economy. You see, $400 billion sounds like a lot, but it’s still small compared with the problem.

Indeed, early returns from the credit markets have been disappointing. Indicators of financial stress like the “TED spread” (don’t ask) are a little better than they were before the Fed’s announcement — but not much, and things have by no means returned to normal.

What if this initiative fails? I’m sure that Mr. Bernanke and his colleagues are frantically considering other actions that they can take, but there’s only so much the Fed — whose resources are limited, and whose mandate doesn’t extend to rescuing the whole financial system — can do when faced with what looks increasingly like one of history’s great financial crises.

The next steps will be up to the politicians.

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.